Is higher executive compensation tied to performance?

Massive CEO compensations consist mostly of company shares the executives received via stock options. How much does that value really reflect the work of a company's chief executive?

Last week the WSJ published a list of the past decade’s best-paid chief executives. You might nod approvingly at some names but gag at others. In the former group is Steve Jobs of Apple, whose company’s share value grew by about 11-fold in the period from 2000 to 2009. In the latter category is Richard Fuld, the last chief executive of Lehman Brothers, whose $457 million compensation during the decade is hard to swallow given what happened to Lehman.

It is notable that these compensation figures consist almost entirely of the value of company shares the executives received via stock options or as restricted stock. It is stock awards that account for the big numbers, starting with the $1.84 billion that won Larry Ellison of Oracle the top spot in the ranking. Cash salaries by comparison are miniscule.

The obvious argument in favor of stock options is that they give executives incentive to work at boosting share value—thereby serving the owners of the company. But do they really have to be given such large blocks of stock? Smaller amounts of stock are likely sufficient incentive.

Giant compensation packages can’t really be justified as necessary to retain executives. It is not credible that Messrs. Ellison and Jobs would have jumped ship had they been paid less. I would guess that with smaller stock options they’d continue to do what they’re doing.

Neither is it plausible that company boards, compensation committees and their consultants have a reliable way to estimate the contribution of an executive to a business, even assuming the best of intentions. Certainly Lehman’s board had no clue as to the future of the investment bank—nobody did until it collapsed. After the fact, Mr. Fuld’s compensation looks outrageous. Yes, hindsight is 20/20.

In any case, it is hard to argue that these people in some sense merit gigantic stock packages, especially as American executives tend to make much more than their counterparts elsewhere. Certain companies on the WSJ list did very well by their shareholders, but even then it is unclear whether the CEO had to be given that much stock. Social norms as well as personalities and market psychology no doubt come to play.

As does chance. Others with similar abilities and drive competed for these prizes. They failed because of bad decisions but also because they were on the wrong side of Lady Luck. Randomness, as Nassim Taleb reminds us, is a powerful force that we tend to overlook. The top earners are the winners in a complicated sort of lottery. Their wealth is in part a result of happenstance.

Yet executive compensation has a crucial social function in fueling the engine of growth and innovation. The bigger the potential pot, the more participants in the race to build businesses and bring out new products. Only a few win huge awards, but the prospect of winning attracts capable individuals. The lottery needs to offer large awards so people will participate.

While executives could be paid less, the glittering prizes encourage their would-be successors. You want youngsters to aspire to be the next Steve Jobs. Many of them won’t succeed, but they’re the creative power in the economy.

The WSJ compensation data do not indicate whether an executive sold his shares. As I recall, Fuld did not cash out before the 2008 crisis, meaning he did not actually make all the money that put him on the list. One could see that as yet another example of his poor judgment, but it is also another instance of bad luck.

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